How Do Taxes Affect Human Capital? The Role of Intergenerational Mobility

Abstract

Existing studies of the effects of taxation on human capital accumulation are based on models with extreme intergenerational mobility properties. One strand of the literature uses life-cycle models, in which intergenerational mobility is perfect. Another strand relies on models of infinitely lived dynasties, in which intergenerational persistence is perfect. Hendricks (1999a) shows that the predicted tax effects differ in important ways across the two model classes, in large part due to the extreme mobility properties implied by standard infinite horizon and life-cycle models. It is therefore important to study the effects of taxes in environments with realistic intergenerational mobility properties. To this end, this paper develops an overlapping generations model of taxation and human capital accumulation which matches features of the intergenerational transmission of earnings and education estimated from a panel of U.S. workers. The main finding is that abstracting from the intergenerational transmission of human capital, as is typically done in life-cycle models, has little impact on the predicted effects of tax reforms. In contrast, models with extreme degrees of intergenerational persistence, as implicit in infinite horizon models, generate very different outcomes. This finding cautions against the use of infinite horizon models of human capital accumulation.